This insight was originally published as a guest article in Global Custodian. Click here to view.
The rapid collapse of Archegos Capital Management in late March has prompted the world’s biggest investment banks to re-examine the risk management processes in their prime brokerage divisions. This stems from how Archegos, the family office of Tiger Management alumnus Bill Hwang, didn’t just lose the estimated $10bn in private money that it managed; it cost its eight prime brokers in excess of $10bn as well.
Prime brokerage refers to a set of services that investment banks offer to hedge funds and, increasingly, family offices. Its core components include margin lending, which allows hedge funds to borrow against the assets they are acquiring and thereby invest multiples of their underlying asset base; sourcing stocks that can be lent to short-sellers; and total-return swaps, which provide an investor with economic exposure to assets that the investment bank officially owns and manages on their behalf.
Since the financial crisis, the prime brokerage industry has been subject to downward pressure on the profit margins generated by these services. Changes in market structure, regulatory environment, and technology have commoditized banks’ prime brokerage offerings, driving fierce competition and pushing rival banks to undercut one another on fees and risk tolerance.
Compressed margins and increased competition will inevitably affect the risk-return dynamics of any business line. In order to sustain the significant revenue streams of their prime brokerage divisions, banks may be tempted into taking more aggressive positions. Credit Suisse reportedly generated $17.5m in fees from Archegos in the preceding year – a meaningful chunk of revenue, but one dwarfed by the >$5bn write-down that it ultimately suffered. The bank is now said to be planning to scale down its prime brokerage arm, reducing its lending to hedge funds by $35 billion, or approximately one third.
It is important to recognize that certain risk factors on show here originated in the very same structural changes that have made prime brokerage a more competitive and crowded industry over the past 10 years
Other investment banks will maintain that a very attractive trade-off between risk and reward remains on offer in the prime brokerage market. Recent research from Aite Group found that global prime brokerage revenues have grown 8% annually since 2015 to surpass $30bn last year. As well as generating substantial fees, a prime brokerage offering can help build holistic relationships with hedge fund clients who will pay for other services. What these banks need to do is understand to what extent the Archegos collapse was either an aberration or a product of current market conditions, and then review their risk management processes accordingly.
Placing Archegos in context
Many aspects of the Archegos implosion were exceptional and unprecedented. The family office’s initial bets on a concentrated portfolio of technology stocks were phenomenally successful and the rising share prices should have derisked the margin loans. Archegos instead used the increased value of its assets to collateralize new loans and invest in more stock, in what became a virtuous cycle. Other investors riding the wave would have been unaware of this single ‘whale’ investor, because the use of total-return swaps meant it didn’t technically own any stock. In March, the cycle turned vicious, when the share prices of companies in which Archegos was effectively the largest shareholder began to drop. The firm became a forced seller, having to liquidate positions to meet its banks’ margin calls and driving prices down further.
However, it is important to recognize that certain risk factors on show here originated in the very same structural changes that have made prime brokerage a more competitive and crowded industry over the past 10 years.
Even Archegos’s existence as a prime brokerage client is symptomatic of the increased number of mandates up for grabs post-GFC. This has been driven largely by family offices investing in hedge-fund-style levered strategies to enhance returns in a low-yield word. In itself this is good news for prime brokers, but it has been accompanied by a range of other challenges.
For example, that Archegos was able to access margin loans and other prime brokerage services on such accommodating terms is partly a function of a buoyant but crowded market conducive to banks taking on higher levels of risk.
Despite these pressures, which Archegos has variously highlighted or intensified, we expect a restructuring and consolidation of the prime brokerage market, rather than widespread retreat
Another industry trend that contributed to the Archegos collapse was the rise of the ‘multi-prime’ model. Lehman Brothers’ collapse in 2008 starkly illustrated the dangers of concentrating counterparty risk in one prime broker, encouraging a shift from one provider to multiple. The commoditization of the industry has also enabled easier like-for-like comparisons in terms of fees, risk tolerance, or trade execution. As a result, hedge funds with over $5bn in AUM now have more than five prime brokers on average, according to Aite Group research.
Combined with the anonymity afforded by the use of total-return swaps, each of Archegos’s multiple prime brokers suffered from a critical lack of information on the size and concentration of the levered bets their client had made with its other prime brokers. This led each bank to underprice the risk associated with its own margin loans.
While these markets developments made it difficult to establish a view of an individual counterparty’s exposure across the entire market, the rapid pace of technological change posed the same problem within individual organizations. Unwieldy technology estates and legacy systems can prevent banks from taking a consolidated global view of client risk across their different platforms and asset classes. Credit Suisse’s risk management systems reportedly struggled to keep pace with the growth of the bank’s exposure to Archegos because of an incomplete roll-out of dynamic margining.
Not every aspect of the Archegos situation was prefigured by the way in which the prime brokerage industry has changed over the past 10 years. While rising regulatory scrutiny has been a feature of the market since 2008, this situation is being held up as a failure of oversight and a result of insufficient regulation.
Critics have pointed to requirements set out in the Dodd-Frank Act for institutional clients of prime brokers to post initial margin which have not yet been fully implemented. Total-return swaps have likewise been criticized for obscuring ultimate economic ownership, with the SEC yet to implement the kind of reporting requirements for these security-based swaps as is mandated of swaps regulated by the Commodity Futures Trading Commission (CFTC). Dan Berkovitz, a commissioner at the CFTC, also described the situation as “a vivid demonstration of the havoc that errant large investment vehicles called ‘family offices’ can wreak on our financial markets”, suggesting impending regulation of a growth client segment for prime brokers.
It will be the biggest firms with the best risk-management software, but also the ability to respond to upcoming regulatory change, who will be optimally positioned to increase their dominance of the industry
We should therefore expect that we will see further regulatory action around ownership, control, record-keeping, and capital. The SEC may extend regulations around security-based swaps, mandating disclosures at certain indirect ownership or voting right thresholds. This would mimic the way in which more stringent regulation followed the financial crisis or the 2011 bankruptcy of derivatives broker MF Global, intensifying margin pressures and necessitating digital transformation.
What this means is that, while the Archegos collapse was symptomatic of some of the challenges that have emerged within prime brokerage since 2008, where that wasn’t the case, it will only serve to compound them.
Despite these pressures, which Archegos has variously highlighted or intensified, we expect a restructuring and consolidation of the prime brokerage market, rather than widespread retreat. It remains a fast-growing and potentially lucrative opportunity set. A reduction in the number of scaled players might also reduce competitive pressures and throw the multi-prime trend into reverse.
It will be the biggest firms with the best risk-management software, but also the ability to respond to upcoming regulatory change, who will be optimally positioned to increase their dominance of the industry. Archegos has demonstrated the enormous risk that large defaults can deal to an otherwise profitable business and fired the starting gun on further regulatory change. Prime brokers therefore need to review their risk models and understand whether and why their existing controls would not have picked up on these risks, while preparing to remodel their systems to accommodate new regulations.